There is a saying that diversification is “the only free lunch in investing.” Since its inception, diversification has fundamentally changed the way people plan their portfolios and handle investment risk. It has become so central to investing that most retirement accounts sink all of their value into mutual funds and exchange-traded funds, which feature diversity by their very nature of investing in a pool of assets.
However, just like a different saying, it’s possible to have too much of a good thing. First coined by legendary investor Peter Lynch, “diworsification” is the act of diversifying a portfolio to such an extent that its returns are damaged.
When diversifying appropriately, you sacrifice some of your potential for returns in exchange for lower portfolio risk. But when you over-diversify, you continue to give up potential returns even though your risk profile can no longer be significantly lowered. Although diworsification sounds like a problem that an investor would have to create deliberately, it often occurs in portfolios by accident. Here’s how you can limit diworsification:
Abandoning old retirement accounts
Much of diworsification stems from account neglect— like forgetting to roll over a 401(k) when you leave a company—which leads to an inefficient use of your money. As you slowly move toward your retirement, your investment should be reevaluated and updated. Old abandoned account(s) will contain outdated strategies that could be spreading your money among investments that no longer have a place in your investment strategy. Roll over and consolidate retirement accounts whenever it is possible to do so without paying large fees.
Overlapping mutual funds
Diversity is good, but diversifying multiple accounts individually can lead to useless repetition. When new (or old) retirement accounts are outside of a coordinated investment strategy, they are often set up to behave like a miniature portfolio, diversifying among the same type of mutual funds that are already used in other accounts. This creates a needlessly high level of diversification within single sectors and can potentially increase the amount you spend on management fees.
Diversifying with weak assets
Diversification should aim to balance a portfolio with the strategic purchase of quality assets, not simply any investments that move independent or opposite of each other. It can seem like a smart move to balance every dollar you put into a company by putting one into its competitor, giving you diversity that captures the growth of a common industry while reducing risk of a single company failing. But, if one company is clearly better managed and more successful, this kind of diversity will only weigh down your average returns while doing little to lower your exposure to industry risk.
Collecting too many pet stocks or funds
There is no clear number of investments required to reach “true diversification.” Similarly, there is no threshold of different investments when a portfolio becomes over-diversified. But you need to keep your other investments in mind when picking up shares of pet stocks that have caught your interest. If you find yourself investing in dozens of sector funds or hanging onto scores of individual stocks you lost interest in years ago, chances are your money is spread thinner than it needs to be.
What’s the best way to avoid (or fix) a diworsified portfolio?
Diworsification is not the most serious problem a portfolio can have, but it does tend to lower returns and, if applied to a specific sector, can actually lead to overexposure and higher risk. The best way to avoid being over-diversified is to keep investment accounts consolidated and check that new investments make a meaningful contribution to your portfolio.
The key to fixing an overly diversified account is recognition of the issue. Gather the account reports for any outlying or neglected investment accounts before planning, and be open about your investments when meeting with your financial advisor. Together, you can consider each investment’s role within your portfolio and determine whether it can efficiently work with your overall strategy.
